Cash Is Not Trash: How to Maximize this Asset Class

What place does cash have in a portfolio? Some advisors tend to dismiss it - particularly in the current interest rate environment. But consider the impact of cash returns (best case, worst case and actual case) in a broadly diversified, 12-asset portfolio.

Cash has hardly been most everyone's whipping boy. During the 34-year period from 1948-1981, the federal discount rate trended upward, rising to a now-astounding 13.42% from 1.34%. During this time frame of rising rates, the 34-year average annualized return for U.S. cash (as defined by three-month Treasury bills) was 4.49%.

Starting in 1982, the federal discount rate began its long descent. At the end of 2011, the federal discount rate was 0.75%. But even during the last 30 years (1982-2011), the average annualized return of U.S. cash has been 4.88% - slightly higher than during the period of rising rates.

HIGHS AND LOWS

The heyday of cash was in 1981, with a one-year return of 15.58%. The low point for cash is, well, now: For 2011, the one-year return of cash (three-month Treasury bills) was 0.05%.

Given a sufficiently long time frame, cash has generated an annualized return of above 4% - whether in a rising or declining interest rate environment. But, of course, not everyone has a 30-year (or longer) investment horizon in which to allow regression to the mean.

So investment advisors must consider this: If cash rates stay low, should they avoid holding cash in client portfolios?

First, let's clarify a few issues. We're not talking about people who hold all their money in cash; this is about cash as a component in a broadly diversified, 12-asset portfolio. And for the sake of this article, we will assume a 10-year investment horizon. With that established, let's examine the impact of cash returns (best case, worst case and actual case) in a broadly diversified, 12-asset portfolio.

As shown in the Performance of a Broadly Diversified Portfolio chart on the proceeding page, my 7Twelve Portfolio includes seven core asset classes plus five additional categories to fully cover all investment options. They are equally weighted at 8.33%. All 12 assets are rebalanced annually. During the 10-year period from Jan. 1, 2002, to Dec.Ã¢â‚¬â°31, 2011, the performance of the portfolio (using the performance of 12 raw indexes) was 8.93%, with a standard deviation of annual returns of 15.30%. The actual annualized performance of U.S. cash during this 10-year period, using the annual returns of the 3-month Treasury bill, was 1.91%.

WORST-CASE SCENARIO

Next, insert the worst case: taking the poorest performance over 10 years for U.S. cash since 1948 and measuring what the impact would be.

As shown below in the Worst-Case Cash chart above, the worst 10-year period for U.S. cash between 1948 and 2011 was from 1948 to 1957. During that span, U.S. cash produced an average annualized return of 1.61%. The overall return of the 12-asset portfolio dropped to 8.91% from 8.93%, a decline of 2 basis points. The standard deviation of the 12-asset portfolio was unchanged.

What this tells us: The most recent 10-year period (2002-11) has been one of the worst for cash on record, inasmuch as the actual portfolio performance and the Worst-Case Cash performance are so similar.

BEST-CASE SCENARIO

Finally, as shown in the Best-Case Cash chart on the proceeding page, consider the returns of the best 10-year period for U.S. cash, which happens to be the period from 1978 to 1987. During this 10-year period, cash generated an impressive annualized return of 9.81%.

The impact of superior cash returns on the portfolio was beneficial, of course, with the 10-year return of the 12-asset portfolio increasing to 9.60%. The 10-year standard deviation of 15.34%, however, is essentially unchanged from the Actual Cash Return Portfolio and Worst-Case Cash Portfolio.

A summary of the scenarios - based on actual cash performance, worst-case cash performance and best-case cash performance - is provided in the Cash Summary chart above.

UNDERSTANDING THE PAYOFF

For investors that place all their investments in one asset, such as bonds or stocks or real estate or cash, timing is everything. The difference between the worst-case 10-year time period and best-case 10-year time period for a 100% U.S. cash portfolio was 820 basis points - resulting in a performance differential of $13,757 within a diversified portfolio that had a starting balance of $10,000.

For an investor using a diversified approach (in this analysis, a 12-asset portfolio), the performance differential at the portfolio level between the worst-case cash returns and the best-case cash returns was 69 basis points, or $1,531 in ending account value.

Are 69 basis points a compelling differential? Maybe so, but only because we could identify the worst-case cash returns and best-case cash returns after the fact. Going forward, obviously, we don't have that luxury. Completely avoiding any asset class in a diversified portfolio amounts to a guess that a particular asset class will underperform and that another asset class will outperform.

But building prudent portfolios is not about guessing and timing. It's about broad diversification. A broadly diversified portfolio is naturally insulated - not completely, but largely - from the normal swings in performance among its various components. The underperformance of one or even several of its ingredients will not sink the overall performance of a diversified investment portfolio.

Craig L. Israelsen,Ph.D., is a Financial Planning contributing writer in Springville, Utah, and an associate professor at Brighham Young University. He is the author of 7Twelve: A Diversified Investment Portfolio With a Plan.